Gnomes

Highlights

• 15-year fixed-rate pass-through securities by Freddie Mac.
• Issued under Freddie Mac's cash program.
• Provide stable, long-term investment income.

Gnomes are 15-year fixed-rate pass-through securities issued by Freddie Mac under its cash program. These securities play a significant role in the mortgage-backed securities market, offering investors a reliable source of income with relatively low risk. Named creatively, Gnomes are designed to provide stable cash flows by passing through principal and interest payments from a pool of mortgage loans to investors. This makes them an attractive option for investors seeking long-term, fixed-income investments.

Understanding Gnomes

Gnomes are part of Freddie Mac's mortgage-backed securities (MBS) portfolio, specifically issued under its cash program. As fixed-rate pass-through securities, they receive payments directly from a pool of underlying mortgage loans. These payments, which consist of both principal and interest, are passed through to investors, hence the name "pass-through" securities.

One of the key features of Gnomes is their 15-year fixed-rate term, which provides investors with a predictable income stream. This stability is especially appealing to conservative investors who seek consistent returns without the volatility associated with other types of investments. Additionally, the fixed-rate structure helps investors plan their income more accurately, making Gnomes a preferred choice for long-term financial planning.

Issuance Under Freddie Mac's Cash Program

Freddie Mac, formally known as the Federal Home Loan Mortgage Corporation, is a government-sponsored enterprise (GSE) that plays a crucial role in the U.S. housing finance system. It purchases mortgage loans from approved lenders, pools them, and issues mortgage-backed securities like Gnomes. These securities are then sold to investors, providing liquidity to the mortgage market and helping to stabilize interest rates.

Gnomes are issued under Freddie Mac's cash program, which is designed to purchase mortgages from lenders in exchange for immediate cash. This program allows lenders to replenish their funds, enabling them to provide more loans to homebuyers. In return, Freddie Mac pools these mortgages into securities like Gnomes, which are then sold to investors.

The cash program helps Freddie Mac maintain a steady supply of mortgage-backed securities, ensuring that the housing market remains liquid and accessible to borrowers. By issuing Gnomes under this program, Freddie Mac contributes to the overall stability of the housing finance system.

How Gnomes Work

Gnomes function as pass-through securities, where the payments from the underlying mortgage loans are directly passed through to investors. These payments typically include:

• Interest Payments: Investors receive fixed interest payments based on the mortgage interest rates of the underlying loans.
• Principal Repayments: As homeowners make payments on their mortgages, a portion of the principal is repaid and passed through to investors.

The 15-year fixed-rate structure means that both the interest and principal payments are predictable and consistent throughout the life of the security. This predictability is beneficial for investors seeking stable, long-term income.

However, one of the key risks associated with Gnomes is prepayment risk. Homeowners have the option to prepay their mortgages, especially when interest rates decline, resulting in a faster return of principal to investors. While this reduces the duration of the security, it also means that investors may have to reinvest the returned principal at lower interest rates, potentially affecting their overall return on investment.

Investment Benefits of Gnomes

Gnomes offer several advantages to investors:

• Stable Income Stream: With fixed-rate payments over a 15-year term, investors receive consistent cash flows, making Gnomes an ideal choice for those seeking predictable income.
• Low Credit Risk: Since Gnomes are issued by Freddie Mac, a government-sponsored enterprise, they carry an implied government backing, providing a high level of credit safety.
• Liquidity: As mortgage-backed securities, Gnomes are actively traded in the secondary market, ensuring liquidity for investors who wish to sell their holdings before maturity.

These features make Gnomes particularly appealing to risk-averse investors, such as retirees or income-focused investors, who prioritize stability and security over high returns.

Risks and Considerations

Despite their benefits, Gnomes are not without risks. The primary risks associated with investing in Gnomes include:

• Prepayment Risk: If homeowners pay off their mortgages early, investors receive the principal sooner than expected. This could result in reinvesting at lower interest rates.
• Interest Rate Risk: When interest rates rise, the value of Gnomes may decline, as newer securities with higher yields become more attractive.
• Inflation Risk: Fixed payments over a 15-year term may lose purchasing power if inflation rises significantly.

Investors should carefully consider these risks and evaluate their investment goals before purchasing Gnomes. Diversifying their portfolio across different asset classes can help mitigate some of these risks.

Comparison with Other Mortgage-Backed Securities

Gnomes are similar to other mortgage-backed securities, such as Freddie Mac's Gold PCs and Fannie Mae's MBS, but they are distinguished by their 15-year fixed-rate term. In comparison:

• Gold PCs: Typically offer 30-year fixed-rate terms, providing a longer duration investment option.
• Gnomes: With a shorter 15-year term, they provide a faster return of principal and less interest rate risk compared to longer-term securities.
• Fannie Mae MBS: Similar structure but issued by Fannie Mae, another GSE, and may have different underlying mortgage loan characteristics.

Investors can choose among these securities based on their investment horizon, risk tolerance, and income requirements. Gnomes are particularly suitable for those seeking a balance between duration and income stability.

Conclusion

Gnomes are 15-year fixed-rate pass-through securities issued by Freddie Mac under its cash program, designed to provide investors with a stable and predictable income stream. With their fixed-rate structure and low credit risk, Gnomes offer a secure investment option for conservative investors looking for consistent returns. However, like all mortgage-backed securities, they come with certain risks, including prepayment and interest rate risks. By understanding the features, benefits, and risks associated with Gnomes, investors can make informed decisions and strategically include them in their investment portfolios for long-term financial stability.